Holt 7525-9 S15_IT

achieve financial

achieve financial security. However, if a person believes that it is impossible to achieve financial security, that person will not take the steps necessary to achieve financial security. 2. Invest in your human capital. Investing in human capital is a way to increase one’s earning power. Investing in human capital pays an even higher return today than it did in the past. Example 17: In 1974 male college graduates earned 27% more than male high school graduates. In 2014, male college graduates earned 87% more than male high school graduates. It is possible to achieve financial security with a low level of income. But it is much easier (and more pleasant) to achieve financial security from a higher level of income. 3. Make good personal choices. No one sets out to make bad personal choices. But people often do make choices that hinder their attempts to achieve financial security. Good personal choices are particularly crucial in three areas: a. Health. Maintaining good health is essential to achieving financial security. Health problems not only lower a person’s quality of life, but also reduce income earning potential. Most workers reach their peak earnings and their peak savings rate relatively late in their careers. Poor health may prematurely end a career before financial security can be achieved. b. Marriage. A successful marriage is advantageous to achieving financial security. An unsuccessful marriage can be a severe hindrance to achieving financial security. Marrying wisely, with a commitment to having a successful marriage, is a big step toward achieving financial security. c. Self-control. Many high income persons have ended up in bankruptcy court because of a failure to exercise self-control in spending. Whatever a person’s income level, one must be able to live within that income in order to achieve financial security. 4. Get on the good side of compound interest. Compound interest refers to interest paid on interest. Compound interest is the saver’s best friend and the borrower’s worst enemy, as illustrated in the examples below: Example 18A: Starting at age 23, Saver puts $100 per month into a 401(k) savings plan. (The earnings on a 401(k) savings plan are not taxed until the earnings are withdrawn, usually at retirement.) Saver’s contributions earn a 10% annual return. (The S&P 500 earned an average annual rate of return of about 10% from 1964 through 2013.) At age 67, Saver will have contributed a total of $52,800. Saver’s investment will be worth $824,973 (over 15 times the amount of Saver’s contributions), and Saver will be earning investment income of over $6,800 per month. Example 18B: Length of time is crucial to the power of compound interest. Starting at age 45, Saver puts $200 per month into a 401(k) savings plan. Saver’s contributions earn a 10% annual return. At age 67, Saver will have contributed a total of $52,800. Saver’s investment will be worth $180,514 (about 3.4 times the amount of Saver’s contributions). Example 18C: Rate of return is also crucial to the power of compound interest. Starting at age 23, Saver puts $100 per month into a 401(k) savings plan. Saver’s contributions earn a 5% annual return. At age 67, Saver will have contributed a total of $52,800. Saver’s investment will be worth $186,247 (about 3.5 times the amount of Saver’s contributions). Example 19: Compound interest is also powerful at building debt. Starting at age 23, Borrower borrows $100 per month on a credit card that does not require a minimum payment. Borrower’s interest rate is 12%. At age 67, Borrower will have borrowed a total of $52,800. Borrower’s debt will total $1,547,060 (over 29 times the amount that Borrower has borrowed) and Borrower will be incurring interest on the debt of almost $15,500 per month. FOR REVIEW ONLY - NOT FOR DISTRIBUTION Income Distribution and Redistribution 31 - 10

Appendix: Income Inequality around the World The degree of income inequality in the U.S. was discussed earlier in the chapter. What about income inequality in the rest of the world? Some general comments can be made about the distribution of income in the rest of the world. But first we introduce a new measure of income inequality: the Gini coefficient. The Gini coefficient was developed by Italian statistician Corrado Gini. The Gini coefficient is a measure of income inequality based on the Lorenz curve. The Gini coefficient is calculated as the ratio of the area indicating the degree of inequality and the area beneath the line of perfect equality. The Lorenz curve below illustrates the two areas. % of Income 100% - 80% - 60% - 40% - 20% - Perfect Equality 0% 0% 20% 40% 60% 80% 100% a. % of Households b. Actual Distribution The area indicating the degree of inequality is the area between the line of perfect equality and the actual distribution curve. This area is identified by the letter a. The area beneath the line of perfect equality is the sum of area a. and area b. So the formula for the Gini coefficient is: Gini coefficient = a. ÷ (a. + b.) The higher the Gini coefficient, the greater the degree of income inequality. Based on Gini coefficients, some general comments can be made about income inequality around the world: 1. The Gini coefficient for the United States is 45. 2. The other members of the top five largest economies in the world have the following Gini coefficients: China, 47.3; India, 36.8; Japan, 37.6; and Germany, 27. 3. The Scandinavian countries have a low degree of income inequality. Denmark, Finland, Norway, and Sweden have an average Gini coefficient of 24.9. 4. The Gini coefficient for the European Union is 30.6. 5. Less developed countries tend to have greater income inequality than developed countries. 6. Some of the highest Gini coefficients are found in Latin America and Africa. Example 20: Gini coefficients from selected Latin American and African countries: Bolivia, 47.0; Brazil, 51.9; Chile, 52.1; Colombia, 58.5; Guatemala, 55.1; Honduras, 57.7; Lesotho, 63.2; Namibia, 59.7; Panama, 51.9; Paraguay, 53.2; South Africa, 63.1; and Zimbabwe, 50.1. The Gini coefficients detailed above are from the CIA World Factbook. FOR REVIEW ONLY - NOT FOR DISTRIBUTION 31 - 11 Income Distribution and Redistribution